Chairman Baucus, Ranking Member Grassley, and Members of the Committee: It is an honor to appear before you to discuss "Climate Change Legislation: Allowance and Revenue Distribution."

In my testimony, I make the following major points.

Free allocation of cap-and-trade allowances to firms in unregulated markets is equivalent to imposing a carbon tax while using the revenue to make transfer payments to stockholders.

This policy harms economic efficiency, because cap-and-trade increases work and investment disincentives, an effect which cannot be offset under free allocation. This policy also leads to a more unequal income distribution because low and middle-income consumers pay higher prices for carbon-intensive products while wealthy stockholders benefit from the free allocation.

Auctioning the allowances can address both the efficiency and distributional concerns, if the auction proceeds are properly used. Marginal tax rates can be reduced and compensation can be provided to vulnerable consumers.

The free allocation of allowances to price-regulated electric utilities is also unwise. If the benefits are flowed through as reductions in the fixed component of electricity rates, the allocation provides consumer relief, but less effectively than could be done through the proper use of auction proceeds. If the benefits are flowed through as reductions in variable electricity rates, as is likely, free allocation increases the nationwide cost of reducing carbon dioxide emissions and consumer relief in the regulated sector is accompanied by increased consumer burdens elsewhere in the economy.

Adopting a carbon tax in place of cap and trade would avoid the pressure for free allowance allocation and offer a number of other advantages.

I elaborate upon these points below. I begin by considering the case in which prices are unregulated.

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Alan D. Viard is a resident scholar at AEI.